Value-add investments, when done right, can be a profitable tool for building wealth. Investors acquire commercial real estate (CRE) not only with the hope of generating positive cash flow from the monthly rent but also with the expectation of selling it for a profit in the future.
Value-add opportunities allow investors to boost both cash flow and equity in their assets through strategic improvements in appearance, amenities, and management efficiencies.
While value-add investments come with potentially huge upside, they can also potentially come with potentially outsize risk. On the CRE risk-return spectrum, value-add investments come with the greatest amount of risk besides opportunistic investments.
So when is a value-add opportunity not a value?
A value-add opportunity is no longer a value when you overpay upfront or underestimate costs on the back – diminishing the returns you once thought were superior to other investment types like core and core-plus properties.
Value-add investments get all the attention, and while everyone wants to get their hands on them, there are two myths to keep in mind when weighing value-add, core, and core-plus opportunities:
- Myth #1 – is that the risks associated with value-add investments are typically minor and can be remedied or mitigated easily.
- Myth #2 – is that other investment types, such as Core and Core-Plus, can’t compete with returns from value-add assets.
The idea that all risks associated with value-add investments can be easily overcome is false. There are many risks – out in front and hidden – that can rear their ugly heads down the road and prove to be time-consuming or costly to repair, mitigate or remedy.
Some of the potential risks that may be encountered with value-add investments include:
- Disasters turn up during renovations (e.g., striking a water main or gas line).
- Natural disasters.
- Difficult tenants inherited at acquisition who became accustomed to the prior management style/approach.
- Shifts in neighborhood dynamics that were previously unforeseen.
- Not achieving target rents.
- Unable to reduce vacancies or unexpected increase in vacancies.
- Rehab is running behind schedule.
- Rehab costs exceed estimates.
- Undetected foundational or structural issues.
A common mistake investors make when evaluating investment opportunities is focusing solely on value-add assets while ignoring opportunities in core and core-plus properties because of the assumption that they can’t compete with returns from value-add assets.
As discussed, value-add properties are no longer values when an investor overpays upfront or when some of the high-risk factors associated with value-adds materialize. The inability to contain costs upfront or post-acquisition is a recipe for disaster and low gains.
Don’t get me wrong… I am not advocating against value-add properties. On the contrary, value-add properties have always been a vital part of our investment strategy, but so have core and core-plus opportunities, which can still offer better risk-adjusted returns than traditional assets like stocks and bonds.
What’s the difference between core and core-plus properties vs. value-add?
Core properties boast high occupancy (90% or higher) and generate stable, consistent cash flow from established, high-quality tenants locked into long-term leases. They are typically located in prime locations with strong fundamentals with requirements for little to no upgrades.
Core-Plus, like Core properties, tend to be high-quality and well-occupied from the get-go but offers the opportunity to improve cash flow through slight property, management, or tenant improvements.
The value of Core and Core-Plus properties is that they are relatively lower-risk but deliver reliable, consistent cash flow and appreciation that still outperform Wall Street. Sure, value-add properties that perform precisely as modeled will outgain any other investment strategy, but there is reason to consider Core and Core-Plus properties.
Compared to underperforming value-add properties, Core and Core-Plus properties have the potential to outperform their value-add counterparts but without the risks or headaches.
I believe that keeping an open mind about maintaining a healthy mix of value-add, core, and core-plus properties in your portfolio can only help your short-term cash flow and your long-term growth – both contributing to your wealth-building strategy.